The Financial Accounting Standards Board (FASB) established current lease accounting standards over 30 years ago. Since then, lease transactions have exploded in size and complexity. Urged by the Securities and Exchange Commission (SEC) to improve the transparency of lease accounting, in 2006 FASB began working with the International Accounting Standards Board to evaluate standards with an eye to revising them.

The key issue lies in the distinction between capital leases and operating leases. Capital leases show up on the balance sheet as an asset (the leased property) and a liability (the obligation due to the lessor). Operating leases show up on the income statement with current lease payments reflected as operating expenses, and future lease payments reflected in a footnote disclosure.

The operating lease structure is a form of off-balance-sheet accounting, which means the lease obligation is not reported as a liability on the balance sheet. Off-balance-sheet accounting received new notoriety after the Enron implosion. Currently, accounting standards require a lease to be recorded as a capital lease, if the arrangement meets any one of four classification tests established by FASB. As a result of the desirability of operating lease classification, lease parties commonly structure leases in such a way to avoid capital lease accounting by a thin margin.

Expect higher corporate debt

Based on the benefits and obligations arising from lease transactions, a likely new reporting structure would be to de-emphasize legal ownership status and to value the “right to use” an asset and to record this amount as an asset and liability of the lessee. The consequence of this change would be a significant increase in corporate debt. For public companies alone, the increase could be upwards of $1 trillion, according to a SEC study in June 2005 relating to the off-balance- sheet arrangements.

While the debt increase would be basically offset by a corresponding increase in assets, many companies would experience a significant increase in leverage. For example, a company with $150 million in assets, $50 million in liabilities, and $100 million in equity has a debt-to-equity ratio of 0.5, whereas a company with $200 million in assets, $100 million in liabilities, and $100 million in equity has a debt-to-equity ratio of 1.0; same equity, double the leverage.

Another metric of financial risk is the debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratio, which measures a company's leverage relative to operating cash flow. While an increase in debt resulting from revised lease accounting will increase the numerator in this ratio, the shift in classification of lease payments from rent expense to depreciation on the leased asset and interest on the lease financing will increase the denominator as well. Rent expense reduces EBITDA; depreciation and interest expenses do not.

Nonetheless, a shift of operating leases to the balance sheet generally results in a significantly higher debt-to-EBITDA ratio than a company would report under current accounting standards (see chart).

Parsing the effects

How can industry professionals prepare for the potential change? First, understand that any standards change has minimal economic impact to the parties in a lease transaction. The greater impact would be the perception of increased lessee financial risk in the lending community, resulting in a decline in credit terms for properties involving affected lessees.

So, how is the lending community likely to respond? At the more sophisticated end of the spectrum, the capital markets will likely have little or no reaction. Standard & Poor's released a research report in July 2006 indicating that it already capitalizes operating leases in its models.

As credit ratings drive the assessment of credit quality for most credit-tenant lease and single-tenant conduit financing transactions, new lease accounting will most likely have no impact on financing terms available for these transactions.

For transactions involving non-credit tenants, lease accounting changes will require a re-engineering of the models lenders use to underwrite lessee financial risk. The possibility of a misinterpretation of lease accounting changes as an indication of a true economic change in lease transactions creates the potential for a disruption at the lower end of the credit quality scale.

The timeframe required for FASB to implement new standards should allow for lenders of all levels of sophistication to become aware of the potential changes ahead and to structure their underwriting guidelines accordingly. While the form of lease accounting is likely to change, the substance of lease transactions will remain largely unchanged.

Todd Davis, CPA, is a vice president with BMC Capital in Dallas and lecturer of accounting at Texas Christian University in Fort Worth. He can be reached at tdavis@bmccapital.com.